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Bond Life After Katrina

When Hurricane Katrina barged into the Gulf states during late August, most bond pros were pretty down on the asset class.

Most felt there were few sectors that showed any appeal, and recommended investors to mostly stay very short in the yield curve. CD and very short bond funds seemed like the safest bets.

But, the economic environment seemed to change in the wake of the disaster.

Oil prices surged, pushing up costs among companies in a wide number of industries, thus stoking fears of rising inflation.

What’s more, much higher oil prices were cited as a catalyst for the bankruptcy filings of two airlines—Northwest and Delta.

On the other hand, the massive flooding in the Gulf Coast has reduced employment in that area. And, the airline bankruptcies and pinched profits at companies harmed by higher oil prices could put even more people out of work, which could wind up easing inflationary pressures.

In light of these developments, has the fixed-income environment changed? No, say the experts.

“The impact on inflation, economic output, fiscal policy, and the direction of monetary policy has yet to become clear,” UBS concedes in a report dated Sept. 14.

This said, the investment bank figures that economic growth will likely slow down during the third and fourth quarters of this year and then begin to accelerate in 2006 as rebuilding efforts get underway.

“The inflation picture is murkier,” it adds. However, it says signs are pointing to a building of core and headline price pressures through the balance of this year and into 2006. “The fiscal policy impact is clearly negative from a Treasury debt management perspective, but will likely help to limit any erosion in growth prospects brought about by a retrenchment in consumer sentiment or disruptions in important supply routes,” it adds.

UBS also concedes that it has become harder to handicap the upcoming September FOMC meeting. It acknowledges that the futures market is figuring on a 25 basis-point hike, but the UBS analysts expect the Fed to hold off from raising the Fed funds rate. “That said, were the Fed to pause this month, it is likely that tightening would resume before the year is out,” it adds.

More importantly, UBS asserts that even if growth slows down this year due to the effects of Katrina, it still expects bond yields will continue to trend higher over the balance of the year. In fact, it points out that the yield on the 10-year Treasury note has already climbed back to pre-Katrina levels, despite the increased uncertainty with regard to the economic and policy outlook.

“Certainly, bond yields may become more volatile as economic data and damage assessment information are reported,” UBS points out in its report. “In fact, we would not rule out a further near-term decline in the yield of the 10-year Treasury note on any sharply below-consensus economic releases.”

Even so, slower growth this year could be offset by higher-than-expected inflation. In fact, even though the investment bank was anticipating an increase in inflation during the second half of this year and into 2006, it says it is now looking to revise upward these forecasts due to the sharp surge in energy costs and projected supply bottlenecks.

“Therefore, we would look for long-term yields to increase and for the Fed to continue to raise the funds rate to the 4 percent level, which will likely keep upward pressure on the front of the curve,” it adds.

As a result, it says it retains its below-average duration weighting and preference for coupon-enhancing strategies.

“Even if the steepening impact of Hurricane Katrina on the yield curve proves temporary and the curve flattens further or inverts, we do not believe this would portend recession,” UBS adds. “Nor do we anticipate a deep, prolonged inversion. As a result, we continue to recommend investors adopt a laddered (neutral) curve allocation.”

Smith Barney is even more pessimistic. It asserts in a strategy piece that the cost of Katrina and the federal government response could hamper future budget moves, and even lead to the expiration of tax cuts—both of which could have stock price repercussions.

Acknowledging reports that Congress may not renew the dividend rate cuts, Smith Barney states, “any change to dividend tax treatment, for example, could alter investment styles that have benefited dividend-oriented industries such as utilities and REITs.”

Growth stocks also may wind up being favored by investors over dividend-paying stocks in general if capital gains tax treatment becomes preferential again.

As for the effect on the bond market, Smith Barney economists continue to feel that the Fed will tighten two more times, taking Fed funds to a peak of 4 percent, according to a report dated Sept. 15. The timing, however, could be slightly different than expected, it adds.

For example, the investment bank theorizes that the Fed could wind up tightening on September 20, then perhaps skipping November, and then coming back with a fairly unusual December tightening, assuming the economy is performing as anticipated.

“The ultimate impact on long-term rates of Katrina will be negligible: the same factors that have kept long-term rates well-behaved will continue to dominate the rate equation: faith in the Fed, massive dollars in foreign hands because of the current account deficit, a global glut of savings, and near-zero demand for debt capital from nonfinancial corporations,” it adds.

In addition, while higher energy costs could generate additional inflationary concerns, it asserts the Fed is well aware of that risk, and at least so far, higher energy costs have functioned mostly as a tax on economic activity, both in the U.S. and globally.

Merrill Lynch, on the other hand, thinks the Fed may not raise rates on Sept. 20 but boost them at the November 1 meeting and into early 2006.

It adds: “We recommend an emphasis on high-quality issues in the bond market because spreads remain narrow and the initial effects of the hurricane should be to rein-in economic growth.”